Inflation exists when prices rise while the purchasing power of money declines. It's bad for consumers, but it's not always bad for stocks. More accurately, some sectors prove more durable during inflationary times than others, but the utilities sector is usually not a place to seek shelter from inflation.
Rising Input Costs
Rising commodities prices are a hallmark of inflation, and they translate to higher input costs for a variety of companies. Utilities are not immune to rising commodities prices, because most electric utilities in the U.S. use either coal or natural gas to provide power. If commodities prices rise, the price of coal or natural gas will likely rise as well. Because most utilities are regulated by state governments, they cannot automatically pass higher input costs along to customers. That translates to crimped profit margins.
Central banks commonly fight inflation by raising interest rates. Few sectors are as vulnerable to interest rate hikes as utilities are, because utilities are capital-intensive companies; they borrow large sums of money to finance general operations. Many borrow money by issuing corporate bonds. When interest rates are low, companies with good credit ratings can issue bonds at low rates. However, rising interest rates equal increased borrowing costs, which can stifle profit growth for utilities.
Investors embrace utilities stocks for two basic reasons. The sector is perceived to be less volatile than the broader market; in down markets, utilities stocks usually don't fall as far as stocks in the broader market. And the utilities sector is home to a broad swath of solid dividend stocks. When utilities face rising interest rates or higher input costs, though, they often cut their dividends to conserve cash.
Inflation often leads to higher prices for commercial and residential real estate. Elevated real estate prices can lead to demand destruction as buyers and renters become priced out of the market. Unoccupied space means diminished consumption of electricity, which can weigh on a utility company's profits.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.